TechWatch: The New Capitalism?

The current banking and financial crisis that has crippled the world, destroyed jobs, and offers no easy out has led to calls for a new kind of capitalism. It is not surprising coming from some. But then we go back slightly before the current crisis and hear Bill Gates’ voice in this chorus. In his 2008 speech in Davos, Switzerland, to the World Economic Forum, Gates called for a new form of capitalism. His concern was that traditional capitalism was not reaching the poorest of the poor. “… [B]reakthroughs change lives only where people can afford to buy them — only where there is economic demand.”

Then he sketched a hybrid model: “Creative capitalism takes the interest in the fortunes of others and ties it to our interest in our own fortunes — in ways that help advance both. This hybrid engine of self-interest and concern for others serves a much wider circle of people than can be reached by self interest (traditional capitalism) or caring (philanthropy) alone.”

So his argument, before the main force of the current financial crisis, was based on what he thought capitalism could not do that needed to be done. The response to his argument, captured by Michael Kinsley in Creative Capitalism (reviewed in this issue) was amazing. Many responders to his presentation thought Gates was misguided. One argued that he had become personally wealthy from his own capitalistic practice and now wanted to keep others from doing the same. Capitalism works great as it is, many argued. Don’t mess with it.

There is no doubt (in my view) that capitalism has done great things for the world in raising people from poverty. But the strict “Milton Friedman” model has also done significant harm as well. I believe it is behind the ethical crises we have faced over the past decade, including the dot-com bubble; the “corporate greed” wave of scandals identified with Enron, Andersen, Tyco, and the like; and the current banking issues.

To understand why I believe this model is behind the crises, I will use a tool from my technology days when I worked on mathematical software. In particular, I will use what we know about mathematical optimization to analyze Friedman’s stated focus for business, and show what we can learn about the inevitable direction of this focus.

Friedman Premise

In 1970, Milton Friedman put forth the claim, “… the social responsibility of business is to make as much money as possible for the shareholder while conforming to the basic rules of the society, both those embodied in the law and those embodied in ethical custom. … The criterion of performance is straightforward.” September 13, 1970, New York Times Magazine.

Joel Bakan interviewed Milton Friedman for his book The Corporation. He tested the literalness of Friedman’s position, and reported, “There is one instance when corporate social responsibility can be tolerated, according to Friedman — when it is insincere. The executive who treats social and environmental values as a means to maximize shareholders’ wealth — not as ends in themselves — commits no wrong.”

Let’s examine this proposal through the lens of mathematical optimization to see what we can learn. Friedman formulated the problem as a constrained mathematical optimization problem:

Maximize a function (shareholder value) subject to constraints (of the law and ethical norms). He said the criterion is straightforward.

Here are four things we can learn from mathematical optimization.

We Wouldn’t Like the Solution if We Could Get There

We will see in a moment that it is very difficult to solve this optimization problem (maximizing shareholder value). But suppose we could solve it. What would the solution look like? Optimization theory tells us that the solution to a constrained optimization problem lies on the boundary of the constraints.

This says if we could maximize shareholder value subject to the constraints of the law and ethical norms, we would have to operate on the boundaries of the law and ethical norms. What does it look like to operate on these boundaries? Enron might be a good example. John Reed, former chairman of CitiBank, once told us that it wasn’t the laws Enron broke that concerned him, as much as the egregious behavior of Enron acting on the “edge” of the law. Many of the acts coming out of the banking scandals have the same character. They were acting on the edge of the law to make as much money as possible.

So if we could do what Friedman calls for business leaders to do, it would put the business at grave ethical, if not legal, risk. That’s where I believe we have been in all of the ethical waves in the past decade. But it gets worse.

We Can’t Really Get There

The second thing we learn from optimization is that these problems are very difficult. No one really knows how to truly solve most nonlinear, time-dependent mathematical optimization problems (which is the nature of the problem as formulated). So we do in practice what any good mathematician would do — we approximate the problem by something we can solve. In practice, what this means is that while it is very difficult to maximize shareholder value subject to constraints over the long term, we can likely be more effective in doing this over the short term. The pressures from Wall Street for short-term results only support the solution to this problem rather than the stated problem.

It is generally not the case that a sequence of best solutions for the short term will together lead to the best solution in the long term. Anyone hiking in the mountains knows that to get to the peak you sometimes have to move lower before climbing higher. Similarly, short- term thinking in business may look good at the moment, but it often has very significant longer-term issues. This was the theme of Alan Kennedy’s book The End of Shareholder Value. This “solution” does not maximize value for the shareholders, and is still pushing the boundaries of the law and ethical norms.

The Model Is Only as Good as Its Data

A third thing we learn from mathematical optimization is that the model is only as good as its data. And the data is very difficult to get right in the case of running a business. Let’s take an extreme case to demonstrate the point. Should the CEO authorize $1 million of company money to fund a birthday party for his wife? This was one of the ethical issues at Tyco that landed CEO Dennis Kozlowski in prison. Clearly this is one easy case where the answer must be “no.” Unless … the party is a motivator for people involved, they get inspired to try a new idea, and the idea is worth billions to the company. Absurd? Probably. But the point is, knowing what data goes into the model and what it has to do with shareholder value is not straightforward. This brings us to the fourth point.

The Criterion Is Not Straightforward

Friedman stated that the criterion for making choices about shareholder value is straightforward, but it is not. It is difficult to say for sure what a liberal return policy for a retail business means to the bottom line. Does it inspire loyalty in customers? Does it raise costs? Or is it simply the right thing to do? What about a paid service day for employees? Does it build the team and create better working relationships leading to greater productivity? Or is it simply a cost to the company that should not be placed on the shareholders but should be the personal expense of each person participating?

Friedman and Bakan would argue that it is OK to do these things if the leader believes they lead to increased shareholder value, but not OK to do them if it is not justified in this way. The point of this is that for many business situations, the link between an action and ultimate shareholder value is at best difficult to assess.

Added Challenge

My colleague Kim Sawyers, in the School of Business and Economics at Seattle Pacific University, tells me it is even harder than this. Research shows that managers tend to do what is in their compensation plan rather than what is best for shareholder value, whether long term or short term. This means that in order to maximize shareholder value, the company would have to perfectly align the compensation plans of its executives with the goal of maximizing shareholder value. That is an almost impossible task given the complexities of truly maximizing shareholder value and a changing world that makes it tough to be precise about what should go into the next year’s compensation plans.

Conclusions

Business is the only institution that creates, manufactures, and distributes products needed by an increasingly interdependent world. Business is the only institution that generates economic capital. The recent period of focusing business on only the wealth creation for its shareholders should be over. There is more to running a business than the money that business can make for its shareholders.

That said, we should not throw out the baby with the bath. Business has done some great things, and Bill Gates is right when he says we should use the strength of business to help deliver value for the poor.

But as we examine this subject, those who claim that capitalism is great just as it is should be sobered in seeing where it has taken us just in the last decade. Let’s make sure we clearly understand the weaknesses of Milton Friedman’s version of capitalism as a part of the development of new solutions.

Ethix is an online publication of the Center for Integrity in Business in the School of Business and Economics at Seattle Pacific University. Ethix provides illustrations of business ethics challenges through positive examples of best practices and exemplary leadership. More»